Guest Interview:

Schreiner Capital Management, Inc.

111 Summit Drive
Exton,PA 19341

Interview Quarter: 3Q1994

Roger Schreiner

President

Q: Gentlemen, could you give us some insight into your backgrounds?

A: I A: started my investment career with Dean Witter Reynolds. After five years with Dean Witter I moved to Janney Montgomery Scott as Vice President of Investments. In 1981, shortly after the introduction of sector funds, I began developing quantitative investment strategies utilizing industry mutual funds. After many years of research and study, I developed a low-risk, computerized investment approach that we call The SCM Quantitative Sector Rotation Discipline. I have been a resident of Chester County, Pennsylvania, for over twenty years and currently live in West Chester with my wife, Mary and our four children.

Q: Paul, could you tells us a little about your background?

A: My background is slightly different than Roger's. I am a Certified Financial Planner and I taught classes in personal taxation and NASD licensing exam preparatory courses while building a money management service for a financial planner. I was using techniques similar to those Roger had developed in trading accounts, and we found ourselves very much of the same mind philosophically with regards to investing in the equity markets. After working together for two years or so, we formally joined our advisories under the SCM banner. I'm responsible for the back-office and daily operations for our firm, and I do most of the trading. Roger spends most of his time in marketing, but we overlap in many ways in our efforts to provide a high level of service to our clients, and in meeting our stated objectives of providing above market returns with less risk. My wife, Carolyn, and I, with our two children, have also lived in Southeastern Pennsylvania for many years.

Q: I understand that your approach to the market is a little non-traditional. What makes your Sector Rotation investment style so different?

A: Most money managers and individual investors are in constant search for the winning stock, or the inside scoop on the next big market move. Our approach is much different. We focus on preserving assets by diversifying among only the strongest industry sectors during each market phase. This discipline not only helps us to participate in market advances, but has a cushioning effect against losses during market declines. Just about anyone can make money in a good market - but only the very best managers are able to preserve capital when the market declines. Since losses have a significantly greater impact on a portfolio's performance than gains, we believe it makes sense to concentrate on preserving capital, not just on finding winners. You really emphasize the risk-adverse nature of your investment management style.

Q: Can you tell us more about that?

A: We have two primary goals in our investment process: 1) is to reduce market risk, and 2) is to provide returns that consistently outperform the market averages. The fact that we reduce market risk, is really the key to our above average returns. We believe that long-term success is dictated not by how much you make, but by how much you don't lose. Although you'll find many investors who agree with that statement, most investors still focus almost entirely on "how much they can make." When we study the results of our investment discipline over the last few years, we discover that our above market returns over the market cycle come from our ability to preserve money during the unfavorable market periods. For example, when we divide the returns of our Sector Discipline into up and down-periods and measure the monthly returns, we discovered that we captured about 90% of the market's return when the S&P 500 was advancing, while we only experienced about 40% of the losses when the market declined. You really don't need to be a hero on the upside, if you can preserve the bulk of your capital when the market falls. Our beta over the last three years has averaged about 0.57. Most managers who have low betas (low-risk) also have low returns. Our discipline has proven that we can outperform and with less risk.

Q: Are you forecasting industry performance?

A: Our investment discipline is one that concentrates on "recognizing what is happening," as opposed to "predicting what is going to happen." This basic philosophy helps us to avoid a market bias. It keeps us flexible so we can participate in whatever industry sector or investment trend is currently in-favor in today's market.

Q: So you're looking for good industry sectors, not good stocks?

A: That's right. In our analysis, the only "good sector" is one that is performing better than the market. Any sector that is underperforming the market is a "bad sector." We don't particularly care why it's "good" or "bad" - we just want to participate in the good sectors and avoid the bad. We make it a point to know as little as possible about the underlying reasons behind the stock market's moves. We only care about what investors are doing, not why they're doing it. We find it much more valuable to recognize and react, than to forecast and hope. Our decisions are driven by facts, not opinions.

Q: Do you and Paul divide the portfolio responsibilities? Who makes the decisions?

A: All our decisions are arrived at through our computerized quantitative process. We don't make any subjective decisions. We rely solely on our objective technical analysis of price performance among the major industry sectors. Our quantitative method completely avoids forecasting as well as trying to interpret the (so-called) expert opinion. We know that emotions have no part in a rational investment discipline. Our clients pay us to implement our quantitative discipline, not to subjectively interpret market action. We never fall in love with any industry sector, we only want to court the ones that are performing ahead of the class. Our formula-driven decisions are much more valuable than our best guesses. We have a very high degree of confidence in our sector rotation discipline. Both Roger and I monitor the sectors and market performance daily. Each of us independently updates and runs the computer analysis. We then compare our data to confirm the model's conclusions before we schedule tomorrow's actions.

Q: Roger, could you explain your Quantitative Sector Rotation?

A: Of course. Although our algorithm is proprietary, we can describe our investment process in some detail. There is really nothing magical about our formula-driven methodology. It does nothing more than measure relative price performance in a unique way. We avoid the traditional moving-average-methods that are popular today and come pre-packaged in every off-the-shelf technical analysis software program. Instead we rely on a unique but simple computerized formula that analyzes each of the major industry sector's price strength. Our quantitative discipline gives us a measurable edge on the market and generates clear, non-biased signals where we should be invested. Our investment model answers the question as to "which industry groups are performing best in today's market?" Simply put, our goal is always to own the strongest sectors of the market during each market phase. Just as important, we want to be able to avoid the weakest sectors of the market. If a sector is out-performing the market, based on our computer analysis, we buy it or continue to hold it. If it's under-performing the market, we sell it and allocate those sector's assets to the safety of a money market fund.

Q: Paul, explain how you arrive at your cash allocations.

A: Since about half of the sectors will outperform the market and half will underperform the market over the long-term, we average fairly large cash positions, (relative to most money managers). However, on a shorter-term basis, allocations can vary greatly, as the market is quite dynamic. When the market is healthy and rising, more industry groups are outperforming the averages, therefore we have higher allocations to stocks. Historically, we have averaged somewhere between 70 - 85% invested during healthy or rising markets, and often as low as 25 - 40% invested during market declines.

Q: How does a downtrend affect your allocation between mutual fund sectors and cash?

A: Typically, we have lower allocations to the market when it is in a prolonged down trend. When the market is internally weak or generally falling, most sectors are usually under-performing the market averages and we own fewer sectors, and therefore have lower allocations to stocks. There are times when there is no visible evidence of internal weakness - but our discipline does a good job of picking that up. And there are times when we get out-of-step, but it's only temporary. Our discipline has a way of correcting itself over time. Although we have periods of underperformance, it is rare that we're out-of-step for more than a few weeks. It's nearly impossible for us to have high allocations during sustained down trends. The market is always forcing us to sell the weakest groups. Our allocations are dictated by the market itself, not our interpretation of events, market fundamentals, or subjective intuition. Our formula approach automatically makes appropriate allocations to the market during each market phase.

Q: How often do you adjust your portfolio allocations?

A: We're pretty active. Since we measure the market and industry performance daily, we're very sensitive to change. However, we make changes in relatively small increments. Each industry sector in our model represents about 8% of the entire portfolio. Historically, we've averaged about one transaction a week. Sometimes we're very active, and at other times we're very quiet. We let the market dictate our activity and actions.

Q: What is the annual turnover for your portfolios?

A: Our portfolios turn over 250 - 350% a year. That's because industry sectors (stocks) don't stay in positive or negative trends for long periods of time. Our average holding period is only a few months. Because we won't hesitate to sell a sector that's underperforming, we stay pretty active. That's our way of reducing risk. You can't buy-and-hold, and reduce risk at the same time. Since we have no costs to buy or sell sectors, we quickly move our clients' assets to cash when dictated by our program. We know that we can always buy a sector back as soon as it starts to outperform the market.

Q: And how do you invest in industry groups? Do you use individual stocks or mutual funds?

A: Well, rather than create our own pools of industry stocks, we use Fidelity's Select Industry Sector Funds. They offer us some unique advantages over individual stocks. We can usually move in and out of the Select Funds without any cost. Fidelity now offers over three dozen industry sector funds that can be bought and sold every hour during the business day. In our program, we only use twelve of Fidelity's Sector Funds representing the major industry groups of the S&P 500. These twelve sectors give us about a 90% correlation to the stock market. At some point in the investment cycle, we may own three or four industry sectors, while at other times as many as ten or eleven sectors. The more we own, the greater our allocation to the market. We're different than other advisors in that we allocate our client's dollars, representing those sectors that are underperforming the market, to a money market fund, rather than concentrating more assets into the strongest sectors. Although that may seem overly cautious to some, that's one of the major reasons we have done so well during market declines. Our defensive style tends to have more dollars in cash when the market gets in trouble. Since allocations to equities and/or cash determine most of a portfolio's return, we concentrate all our efforts on this important goal.

Q: Don't you miss some great opportunities by not buying individual stocks?

A: We don't think so. Stock-picking is very over-rated on Wall Street. Individual stock-selection has very little to do with return in a diversified portfolio. There have been many academic studies that have proven that individual stock selection accounts for less than 10% of a portfolio's return. Over 90% of a portfolio's return can be accounted for by a) the direction of the overall market, b) industry representation, and c) the portfolio's allocation to stocks and/or cash. We're shocked at how much effort and energy goes into stock-selection when such an insignificant portion of the return is determined by this fashionable activity. Instead, we concentrate our efforts on asset allocation and industry selection, which accounts for nearly all the returns.

Q: In your Sector Rotation Discipline, are you looking for trends?

A: Yes, we're looking for trends, but sometimes they turn out to be blips. Where we differ from most managers is that we don't have a preconceived projection or forecast. Therefore, if the trend doesn't develop and it turns out to be just a blip, we'll get out just as fast as we got in. We don't get caught up in being "right or wrong," we just want to do what is best. If that means taking a small loss, that's okay. We just don't want it to become a big loss. It goes back to my earlier comments about avoiding a bias to the market. More money managers would perform better if they weren't so inflexible and stubborn in their evaluations of the market and their current positions. Too many are fighting to prove that their original selection or prediction was correct. So they hold-on or find reasons to justify their mistakes. Our discipline says avoid predicting and simply recognize what is happening and move in the direction the market dictates.

Q: So, I guess you'd consider yourselves market timers?

A: No. We view ourselves as asset allocators. If you broke our investment process down to its most basic components, you might view it as timing, but we prefer to see it as allocation. And there are a number of ways that we're very different than market timers. Most market timers are 100% in or out of the market. We never take such extreme positions. Each of our industry sectors represents about 8% of the total portfolio, so our allocation to equities is simply 8% times the number of sectors that are currently outperforming the market average. Second, market timers are usually forecasting the market to go one way or the other. We never forecast market direction. We simply invest in those sectors that are outperforming today, and we hold them as long as that favorable trend continues. But we'll be just as quick to sell sectors that are exhibiting price weakness relative to the S&P 500 index. We never predict - only recognize!

Q: So you feel than your allocation discipline is superior to a buy-and-hold or a fully-invested strategy.

A: Very much so! Our discipline not only reduces risk over buy-and-hold, but it also enhances the potential for greater returns. It has worked well for us and our clients. For those who want to stay fully-invested all the time because they're convinced that the market will always go higher, we say, go ahead. To do so, you've got to be willing to take the pain of living through severe bear markets. We can't tolerate losing big money, and we don't like pain. Buy and hold investing is really high risk investing - and high risk investing only works about half the time in the long run. Eventually, the market goes through a correction, and then every few years there's a full-fledged bear market. Those who remain continually optimistic and stay fully-invested reduce their chances of succeeding in the long-run. With our investment discipline, it's possible to enjoy the handsome returns of the bull market, without all the pain of the bear.

Q: How do you answer those who say that despite bear markets, history suggests that you should take your lumps because prices will eventually come back?

A: While the market has bounced back over time, there have been many cases when the wait was very long - in one case nearly twenty years. In the period from October 1964 through July 1984, the total return on T-bills equaled that of the S&P 500. Even though there were some rewarding periods during all those years, you would have taken-your-lumps for so long that you would probably have bailed out of stocks long before the good times returned. Those sharp corrections and long bear markets eventually turn even the most optimistic investors to despair. It becomes a question of how much pain you can take. We prefer to withstand as little as possible. We believe that our sector rotation discipline can provide returns far superior to buy-and-hold, with significantly less risk.

Q: Why should an investor risk so much when he doesn't have to? Would you agree that your disciplined investment style is not for everyone?

A: That's true. Very aggressive investors who are comfortable with buy-and hold and high-volatility strategies aren't going to appreciate our disciplined and mechanical approach. But if you're a growth-oriented investor who is risk-averse and you don't want to lose too much of your money when the market gets ugly, we're probably right for you.

Q: I can see that your philosophies differ substantially from a typical money manager who just picks stocks. Can you summarize the major differences in what you do?

A: Yes, there are several ways that we're different. We manage risk first! We never want to expose our clients' assets to the full volatility of the stock market. With our Quantitative Sector Discipline, we have the ability to get market returns with significantly less risk. Historically, our portfolios have had about half-the-risk of the average equity manager. Usually lower-risk strategies provide sub-par results. However, by lowering our exposure during unfavorable market cycles, our discipline has been able to provide superior returns with about half the risk of the average equity portfolio. Second, while many other managers claim to use quantitative analysis in their investment approach, we take it a step further - our discipline is 100% quantitative. We won't distort our discipline with our best guesses at what the economy is doing, or override our strategy when special news events dominate the wire services. The market tells all. We just systematically analyze price action and respond accordingly. Once again, we never predict, we just recognize and react. Finally, we realize that long term profits are really the result of performing well in bad markets, not simply doing well in good markets. We believe managers should be selected based upon their ability to preserve capital, not just on how well they pick stocks. Too many managers have made their mark by aggressive investing during good markets. While their short-term track records may look appealing during rising markets, most of their return is due to excessive risk. When markets get tough, these aggressive investment styles fall right to the bottom of the performance list.

Q: You say that your philosophy is to "recognize what is happening" rather than "to predict what is going to happen." Explain what you mean by that.

A: We believe that there is a great misconception on Wall Street. Many investors and advisors believe that you must accurately forecast or predict what is going to happen to invest successfully. Nothing could be further from the truth. One never needs to predict if they have a discipline that can recognize changes in trends and take action. Some advisors may disagree with this approach because they feel we're always a few steps behind. While that may be true for some strategies, our discipline is very sensitive to change. We are quick to pick up on new trends. Although it's more exciting to forecast and anticipate the next big move, in most cases emotion wins out over real discipline, and important investment decisions follow the crowd. In too many cases the forecast becomes a commitment, and the investor becomes biased by his own forecast. When the results don't follow, the forecaster often gets stubborn, sometimes even to the point of losing more capital than is prudent.

Q: How have you been able to manage such high return with such a low risk factor?

A: Since we limit our assets to only the most favorable industry sectors - those performing better than the market - we limit our capital exposure. We see no reason to risk capital in industries that "might" be attractive someday. We wait for the market to tip its hand. In weak markets we tend to have greater cash positions, and in stronger markets we tend to have greater equity positions. After all, a manager's ability to properly allocate his investment dollars to cash and equities will dictate his risk-adjusted return. In our case, we let the market dictate those positions for us. We don't need to have every dollar invested to outperform the market, if we own those industry groups that are leading the market. And when the market is in a bear phase, if we own only those sectors that are performing better than the market, (on a relative basis) we don't get hurt badly.

Q: So you believe that your "discipline" gives you an edge. What specifically creates that edge?

A: First, our approach is 100% quantitative. All our investment decisions are made with strict adherence to a proprietary computerized process that has proven reliable in a variety of market conditions. No judgmental, emotional, or subjective information is allowed to enter the decision making process. Second, our portfolios are diversified, not just in lots of stocks, but among only the strongest industry sectors of the market. We refuse to invest in sectors that are underperforming the market. It only increases market risk and the possibility for negative returns. And finally, we are very active in our management. Paul and I monitor and evaluate each industry sector on a daily basis. We only want to expose our clients' assets to those industry sectors that are currently performing ahead of the market averages. Our activity reduces risk, while giving us the opportunity for above market returns.